Viewpoint | July 2009

Manufacturing in China
Opportunities in a competitive market

With the manufacturing sector accounting for 40 to 50 percent of the national economy, the resurgence of economic growth in China depends heavily on the revival of manufacturing in China. Gross domestic product (GDP) growth in the first quarter of 2009 slowed to a 19-year low of 6.1 percent. Exports continued to contract, decreasing 20 percent in the first quarter as global demand remained weak. However, the Purchasing Managers Index (PMI) has rebounded above the 50 benchmark level for four consecutive months and many analysts expect growth to increase as spending from last Novembers RMB4 trillion stimulus package continues to trickle down. Regardless of when Chinas economy recovers, it is clear that the manufacturing landscape for foreigninvested companies has changed. Focusing on China only as a provider of low cost labor for exports is unlikely to be a winning strategy moving forward. With increasing competition and continued rising costs, implementing industry best practices is no longer an option but a necessity.

For more than 20 years, economic growth in China has been fueled by multinational companies taking advantage of the cheap cost base to manufacture low-cost products primarily destined for Western markets. In recent years however, the Chinese government has made an effort to push the manufacturing sector into higher-end, more efficient production and to increase the capability and productivity of Chinese workers. Despite the current global economic climate and idle factories across China, Chinese leaders have maintained a long-term focus on moving up the value chain and developing sustainable growth in key industries. In the meantime, multinational manufacturers and Chinese companies alike are increasingly targeting Chinas domestic market, where demand has slowed but growth remains relatively steady and is expected to increase in the medium to long term. Nonetheless, U.S. companies in the manufacturing sector have been significantly impacted by the downturn. According to AmCham Shanghais second China Manufacturing Competitiveness (CMC) study, released in February 2009 in cooperation with management consulting firm Booz & Company, nearly one out of two respondents suffered an export drop of more than 10 percent in 2008 compared to 2007. In April, the AmCham Shanghai Manufacturers Business Council launched the China General Managers Index (CGMI), a monthly survey of foreign-invested manufacturers in China. The latest results indicate that companies focused on the domestic market have increased year-to-date figures in sales, orders and headcount when compared to export-based companies. Compared to 2008, 44 percent are doing the same or better in terms of sales. Although the overall environment remains difficult for most manufacturers, a clear majority of respondents indicated future order intake over the next three months is expected to increase.

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Major Challenges in Manufacturing

In addition to a decline in exports, domestic sales in China are also dropping, as 40 percent of respondents reported a sales decrease of more than 10 percent, according to the CMC study which polled 108 foreigninvested manufacturing companies in China in the fall of 2008, followed by an update survey of 79 of the companies in late December. Even with the current economic conditions, manufacturing in China has become more expensive. Companies reported that costs are still rising up to 15 percent in 2008 compared to an increase of 10 percent in 2007 particularly in compensation costs for management, support staff and blue-collar workers as well as raw materials. Although labor and raw materials costs have come down from the premium levels of last summer, they are expected to rise again once market conditions improve. Finding reliable, experienced talent has always been a challenge in China and despite rising unemployment during the current downturn, companies must ensure turnover remains at a minimum for when growth resumes. 86 percent of companies reported implementing pay-for-performance compensation plans. 62 percent of companies said they were providing training and development programs.

Duality Continues to Gain Popularity

The initial results of the CGMI indicate that manufacturing companies geared towards domestic sales are currently faring better than export-oriented companies. However, most manufacturers that have been successful over the long term in China have employed a strategy of duality where they focus on the domestic market and also use China facilities to produce for export. These companies typically fare better than those who pursue narrower objectives of either simply taking advantage of the countrys low-cost labor to make inexpensive products for export or importing products into China for sale in the growing domestic market. In 2008, duality as a strategy for China continued to gain prominence. 57 percent of companies in the CMC survey described the duality approach as the primary motive for establishing and growing their presence in China, versus 47 percent in 2007. The percentage of respondents that identified labor or materials cost savings as the primary reason for being in China, but did not cite local market access as a key motive, dropped by half from 22 percent to 11 percent.

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Motives for Setting up Operations In China

Duality players are better positioned and have more motivation to implement best practices in China, because to succeed they must devise factory footprints that produce large volumes of product but delay the moment at which those products have to be customized for Chinese and non-Chinese markets. These companies must do so in globally connected supply chains that are lean and highly responsive.

Best Practices Now Required

The challenging environment for manufacturing presents unique opportunities for companies that are aggressively implementing best practices to improve their market positions in China. In the CMC study, more companies said they are planning to expand manufacturing in China and fewer manufacturers had plans to relocate to another low-cost country than in 2007. Manufacturing among foreign-invested companies continues to evolve steadily, with more companies implementing sophisticated production operations and technologies while also integrating their China operations into their global supply chains. China is expected to be a growth area that will eventually lead the worldwide economic recovery, and multinational companies that are forward thinking will be poised to benefit from implementing best practices now to develop and capture economies of scale and scope. On average, 39 percent of companies surveyed had adopted some aspect of a best practice in 2008, up from 27 percent in 2007.

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Application of Manufacturing Best Practices in China

The CMC survey found that companies that adopted best practices were rewarded with gross profit margins that were, on average, 4 percent higher than those of companies that did not. Nearly one quarter of companies said they were placing new state-of-the-art production technology in their Chinese facilities and half of the respondents said they believed their production technology in China could differentiate their businesses from their rivals. Manufacturers also employ best practices as a response to higher costs as they view these tools as a path to greater efficiency and scale by reducing cost pressures. The most popular best practices currently employed in China include: Optimized product flows and site layout Fully integrated ERP/MRP systems Single piece flow Analytical inventory calculation Optimized cycle scheduling

Average Gross Margin in China

Average EBIT in China

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U.S. Companies Committed to China

Despite the growing popularity of alternative low-cost countries such as Vietnam and India, fewer respondents in 2008 said they had concrete plans to relocate or expand manufacturing capacity out of China in the next five years (10 percent in 2008 versus 17 percent in 2007). Uncertain about the global economic outlook and concerned about economic progress in other lowcost markets, more respondents this year were neutral when asked to comment on whether China was losing its competitive edge to the other low-cost countries. This was a reflection of the slowdown in new manufacturing investments worldwide and the volatility in demand and supply in competing cow-cost countries. As the downturn worsened, companies grew firmer in their desire to invest in China, with nearly 50 percent saying that they intended to grow production capacity over the next few years. 53 percent of respondents indicated they were controlling costs well in the downturn and planned to increase production capacity, while 29 percent said they would open new manufacturing facilities and 44 percent said they would invest in new process technology. 56 percent of respondents are positive about their positioning following the economic downturn and expect the impact of the economic crisis to improve their competitive position in China over the medium to long term.

Recommendations
The global economic downturn has significantly changed the landscape for foreign-invested manufacturers in China and future business strategies must be reconsidered. Before the recession, the biggest challenges were higher material and compensation costs as well as the appreciation of the RMB. Now, lower rates of domestic growth, static demand for Chinese exports, global currency volatility and continued tight credit are paramount concerns. It is crucial for companies to view China less as a low-cost country and more as a competitive manufacturing and sales environment ideally the hub for an Asian growth strategy. Together with Booz & Company, AmCham Shanghai has developed the following recommendations that companies should focus on: Develop a strategy to capitalize on the continued growth of the middle class while reducing dependence on export markets by moving beyond the premium segment and down the price/ performance ladder.

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Develop new business models for the domestic market and tailor current products to meet local preferences and conditions. Align manufacturing and purchasing strategies and link local activities with the extended global supply chain to build and capture economics scale and scope, harnessing the duality of China in the process. Continue to invest in manufacturing best practices to take advantage of latent productivity that exists in most operations to offset rising costs.

To accomplish these objectives, the Chinese government is encouraged to: Maintain efforts to minimize bureaucracy and develop the capital and physical infrastructure that will allow local manufacturing to become increasingly world class. Continue the drive towards higher-end production through emphasis on worker development, innovation, product quality, safety and reliability and protection for the environment and intellectual property. About the Surveys: China Manufacturing Competitiveness (CMC) AmCham Shanghais second CMC survey was released in March 2009. The annual study, conducted jointly with management consulting firm Booz & Company, polled 108 multinational manufacturing companies doing business in China on their perceptions of China as both a sales market and a production center for domestic distribution and exports. The initial survey was completed in August and September 2008 with a follow-up survey in November and December as economic conditions worsened. For a full copy of the 2008-2009 CMC survey, please visit www.amcham-shanghai.org or email Elaine Yang at elaine.yang@amcham-shanghai.org. China General Managers Index (CGMI) The AmCham Shanghai Manufacturers Business Council launched the CGMI in April 2009 to regularly monitor the manufacturing environment in China. The monthly survey polls foreign-invested manufacturers on benchmark sales and sales-related metrics in order to identify the point at which the China market begins its recovery. For more information about the CGMI, please email the AmCham Shanghai Manufacturers Business Council at comm.mbc@amcham-shanghai.org.

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AmCham Shanghai Viewpoint

An analysis of issues impacting todays business environment in China
About the American Chamber of Commerce in Shanghai The American Chamber of Commerce in Shanghai (AmCham Shanghai), known as the Voice of American Business in China, is the largest and fastest growing American Chamber in the Asia Pacific region. Founded in 1915, AmCham Shanghai was the third American Chamber established outside the United States. As a nonprofit, non-partisan business organization, AmCham Shanghai is committed to the principals of free trade, open markets, private enterprise and the unrestricted flow of information. AmCham Shanghais mission is to support the success of our members by promoting a healthy business environment in China, strengthening U.S.-China commercial ties and providing high-quality business information and resources. For more information, please visit: www.amcham-shanghai.org

The American Chamber of Commerce in Shanghai Shanghai Centre, Suite 568, 1376 Nanjing Road West, Shanghai 200040 China Phone: (86 21) 6279-7119 Fax: (86 21) 6279-7643 www.amcham-shanghai.org